Bond insurers are monoline (single industry) insurance companies that provide credit enhancement in the form of a financial guaranty for bondholders. Traditional bond insurers rely on invested cash capital to support their claims paying ability. Capital has historically been provided by a holding company that raises funds by issuing stock (common and preferred) and debt and then depositing a substantial portion of the proceeds in a wholly owned operating subsidiary to capitalize the insurance company. The subsidiary's capital base is used to support guarantee underwriting. For each insured credit, the rating agencies can require that a portion of the insurance subsidiary's capital be set aside to offset the risk exposure. The amount set aside for each credit, which is known as a capital charge, is based on two measures of the quality of the risk underwritten:                The credit type, e.g. state GO, city GO, water and sewer system, school district, toll road, or hospital system; and        The rating of the individual credit for which the capital charge is being assessed.        
The availability of capital to fund the capital charges for new insured credits serves as a constraint on the insurance capacity of the monoline insurer, which can be addressed by raising additional capital.
The basis for the capital charges is the rating agencies' assessment of the risk of municipal default for each credit type and each rating category thereof during a four-year depression scenario. The capital charges represent the anticipated percentage defaults within the insurer's portfolio for each such credit type and rating category. To achieve a AAA monoline rating the insurer's capital can cover the aggregate capital charges (i.e., its assumed four-year depression scenario defaults) by at least 1.25 times. In practice the monoline insurers have been capitalized at slightly higher level, e.g., 1.5 times to 1.6 times. Based on these parameters, monoline insurers habitually accumulated risk exposure at insured risk-to-capital ratios in excess of 100:1. If insured defaults occurred or the credit quality of the portfolio deteriorated so as to increase the monoline insurer's capital charges beyond its available capital, the insurer was expected to raise additional capital to pay claims and to maintain its AAA ratings. But, in a financial crises, raising capital at the time it is needed to fund potential defaults may be difficult or impractical.
The value of the bond insurance product to municipal governments is in the interest cost savings that can be achieved by being able to issue bonds based on the top available long term ratings. The value of bond insurance for the bond investor is based on their willingness to forgo a portion of future investment return (the credit spread) for being directly exposed to the underlying repayment risk of a purchased bond in favor of a lower return on an insured bond rated on the basis of the claims paying ability assigned by the nationally recognized rating services to the bond insurer. In return for providing the additional margin of safety represented by the bond insurance policy, bond insurers charge an insurance premium that is paid, usually upfront, by the municipal bond issuer. The premium is paid from bond proceeds and represents a portion of the issuer's debt service savings.
Monoline insurers may use Collateralized Bond Obligations (“CBO”). CBO creates strong credits (such as loans, bonds, or other obligations) by tranching a large pool of individual credits. The pool can be a large pool of unrated credits such as credit card receivables or a relatively small (e.g., 20 borrowers) pool of rated and/or unrated credits in the case of a municipal State Revolving Fund (“SRF”). The high quality of the more senior CBO tranche(s) is achieved at the expense of the quality of the more junior tranche(s). As the pools get larger, the percentage of underlying credits that can be expected to default decreases even though the absolute number increases. Thus, as the pool becomes larger, the smaller the percentage of total pool that is required to be subordinate, but the more likely it is that a subordinate tranche will in fact sustain losses. The most subordinate tranche is viewed as similar to equity (in the case of an SRF, it is funded with program equity) and bears a large credit and yield penalty.
In general, because the subordinate tranche(s) bear the risk of a default of an underlying credit and adding more credits increases the likelihood that the subordinate tranche(s) will sustain losses (even though losses may decrease on a percentage basis), pools are generally closed unless consent is obtained from the holder(s) of the subordinate tranche(s). As a result, CBOs are generally only used in situations where there is a wide credit and yield spread between the quality of the underlying credits and that of the senior tranche(s) or where there is a compelling business need for someone to hold the equity (e.g., to get the underlying loans off the balance sheet).
Thus, there is a need for new ways to protect against defaults on bond obligations and the present invention provides some solutions to this problem.